In procurement there are two general types of bonds that you may encounter. One type is a bid bond that is used to ensure that the bidder stands behind their bid amount and executes an agreement at that amount. Bid Bonds should be sufficient enough to cover any excess cost of re-procurement if the low bidder is unwilling to sign the agreement. Performance bonds need to cover the amount you would need to pay to complete the work if the supplier or contractor abandoned the work, or failed to meet certain on-going obligations requiring you to hire another party to complete those obligations. Payment bonds cover any contractor non-payments to subcontractors that the buyer could be liable for under Mechanics or Materialman’s lien statutes where a subcontractor could place a lien on the property where they provided services and were not paid. Many times
Performance and payment bonds are issued as a single bond covering both issues. The cost of a bid bond is usually low, to a regular customer of the bonding company they may be provided at not cost. There is not standard cost for a performance bond and the rates will be affected by a number of factors such as:
• The amount of the bond.
• The type of contract being bonded.
• The location of the work.
• The contractor’s financial standing.
• The past job history of the contractor.
• The contractors current work on hand.
Rates usually start at one percent (1%) for low risk situations with highly qualified contractors that have the right risk factors for the bonding company and go up from there, so a contractor with credit issues or financial deficiencies will pay a significantly higher amount that will be passed on to the buyer in the contract price.
There are several factors that should drive the amount of the bonds that are required. A buyer should consider many of the same factors a bonding company would consider:
• The type of contract being bonded.
• The location of the work.
• The contractor’s financial standing.
• The past job history of the contractor.
• The contractors current work on hand.
In addition they need to consider potential inflation and increases in materials or labor costs that may occur in the interim with respect to bid bonds. For performance and payment bonds they should also consider the cost of those bonds versus the value they will provide.
Since bid bonds usually cover a very small period of time, and cover only the additional cost of re-procurement, the amount of any bid bond may be a small percentage of the bid amount. The longer it would take to re-procure something the higher you would want the percentage to be. If the contractor fails to complete the work you would have the following funds to use to pay for another party to compete the work.
• Any amounts not paid to the contractor of the original contract price.
• Any retainage held until completion of the work
• The bond amount to cover the cost.
• You would also have the right to sue the contractor for damages for any additional costs you incur in completing the work that are over and above these three previous sources.
Many times under a performance bond the bonding company may reserve the right to hire another party to complete the work. Their goal is to ensure that the full amount of the bond does not get used. If its clear that the could not be completed for the bond amount they would not exercise their right and would pay the owner the amount of the bond leaving the owner to complete the work. What this does is include another party into the relationship where their sole goal is to mitigate their costs. If you suffered any greater costs you could sue the original supplier or contractor for breach and seek to recover any added costs as damages. If the supplier or contractor had minimal assets you might recover nothing. Conversely, if you had little a highly capitalized supplier or contractor, you wouldn't need a high bond amount or might not need to require a bond. If they failed to complete the work you could sue them for breach and recover any difference in between the contract price and the actual cost to complete the work as damages. I had times where I would bid work and require a performance bond and also have the supplier identify how much they would deduct if we waived the requirement for the bond.
In private procurement where you can be selective of what companies you will allow to bid and could even control what subcontractors were acceptable or not, the decision on bonds and bond amounts becomes a cost versus risk decision. If you aggressively qualify who you allow to bid and hire only companies that have a strong track record of performance with solid financials, the need for bonds becomes less and if you do require bonds the amounts can be less because the risk is less.
In an on line forum one party commented that they preferred to use a letter of credit to cover both performance and payment risks. That’s an option that an owner may prefer as all that is needed is to show the conditions on the letter of credit have been met so the payment needs to be made. The letter of credit does not have the high cost of a bond. It also eliminates having to deal with the bonding company. Few suppliers would like this option as it ties up that portion of their available credit line for the period and would affect their ability to take on other work and finance their operations. To me it’s an option that could work for a contract of a short duration. It would also require very clear conditions that must exist both in the contract and in the letter of credit for the payment under the Letter of Credit to be paid.
